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Seed Weekly - Global Equity or Bonds?

As multi managers we spend a great deal of our time researching the best areas to allocate our clients’ capital – both at the underlying fund manager level, but often more importantly into which asset class and what region.

The end of the Global Financial Crisis (GFC) came some 5 and a bit years ago and now seems like ancient history, but during the GFC investors couldn’t see how it was going to end – there truly were Armageddon stories going around. After a solid 5 years of performance from global equity markets investors can rightly be questioning the wisdom of remaining in global equities over other asset classes, like global bonds, that haven’t performed as well in this period.

The chart below shows the relative performance of the Dow Jones Industrial (DJIA) and MSCI All Country World indices versus Global Bonds over the past 5 years. While the equity indices have more than doubled over this period (returning in excess of 17% pa) global bonds have largely tracked sideways, returning just under 4% pa. Should one be switching to bonds?

At Seed our emphatic answer would be “No!”

Firstly, we do expect equities to deliver materially higher returns than bonds over time. Secondly, and more importantly, global equities (here proxied by the DJIA) continue to offer significantly better value when compared to global bonds (here proxied by the US Government 10 Year Bond (US Govt 10 Yr).

One of the best ways to value an asset is to determine the yield that it is offering and then the prospects in the growth of that yield. Higher yielding assets are naturally preferred to lower yielding assets. One unemotional way of valuing asset classes relative to one another is to compare the relative yields offered by different asset class compared to their historical relationship. This method is used as each asset class will have a different equilibrium yield dependant on its risk profile. When making an asset allocation decision we therefore want to determine whether we are being sufficiently compensated for taking on extra risk.

The chart below shows the difference in yield offered by the DJIA and the US Govt 10 Yr over the past 40 years. It is evident from the chart that the current difference in the yield of the DJIA and US Govt 10 Yr is significantly (more than 1 standard deviation) higher than average. The conclusion from this chart is that equities are offering investors significantly better value than bonds.

A factor that is further in favour of equities is strong expected economic growth in developed markets that will potentially have the impact of stronger earnings for longer (good for equities) and also rising interest rates (bad for bonds) as central banks around the world look to tighten monetary policy.

Where our Fund mandates allow for global exposure, Seed has taken advantage of this valuation differential by being materially overweight global equity, while holding a minimum in global bonds. We have held this position for a while (as this valuation gap has been apparent for a while) and will continue to hold it as long as the valuation gap remains.

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